CHAPTER 25

O P T I O N V A L U AT I O N

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 LEARNING OBJECTIVES
• Describe the relationship among stock prices, call prices, and
put prices using put-call parity
• Describe the famous Black-Scholes option pricing model and its
uses
• Explain how the five factors in the Black-Scholes formula affect
the value of an option
• Demonstrate how the Black-Scholes model can be used to value
the debt and equity of a firm
• Show how option valuation can result in some surprising
conclusions regarding mergers and capital budgeting decisions

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 CHAPTER OUTLINE

• Put-Call Parity

• The Black-Scholes Option Pricing Model

• More about Black-Scholes

• Valuation of Equity and Debt in a Leveraged Firm

• Options and Corporate Decisions: Some Applications

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 PROTECTIVE PUT
• Consider the following investment strategy. Today, you buy one
share of Microsoft for $110. At the same time, you also buy one
put option with a $105 strike price. The put option has a life of one
year, and the premium is $5. Your total investment is $115, and
your plan is to hold this investment for one year and then sell out.
• What have you accomplished here?

• Buying a stock and a put on the stock to limit the downside risk is
called a protective put strategy
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 ALTERNATIVE STRATEGY
• Now consider a different strategy. You take your $115 and purchase
a one-year call option on Microsoft with a strike price of $105. The
premium is $15. That leaves you with $100, which you decide to
invest in a riskless asset such as a T-bill. The risk-free rate is 5%.
• What does this strategy accomplish?
• Your $100 grows to $105 based on a 5% interest rate

• In comparing this table to the one on the previous slide, notice the
two strategies always have the same value in one year
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 THE RESULT
• Protective put strategy can be duplicated by combining a call option
(with same strike price as put option) and a riskless investment
• Put-call parity (PCP) is the relationship between the prices of the
underlying stock, a call option, a put option, and a riskless asset
Share of stock + put option = PV of strike price + call option
S + P = PV(E) + C
• If we assume that R is the continuously compounded risk-free rate
per year, then we could write this as:
S + P = E × e−Rt + C
• Because the PV of the exercise price is calculated using the risk-free
rate, you can think of it as the price of a risk-free, pure discount
instrument (e.g., T-bill) with a face value equal to the strike price
• Easiest way to remember the PCP condition is to remember that
“stock plus put equals T-bill plus call” 25-6
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 PUT-CALL PARITY

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 MORE PARITY

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 CONTINUOUS COMPOUNDING

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 EVEN MORE PARITY

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 THE BLACK-SCHOLES OPTION PRICING
MODEL
• Black and Scholes showed that the value of a European-style call
option on a non-dividend-paying stock, C, can be written as follows:
C = S × N(d1) − E × e−Rt × N(d2)
• S, E, and e−Rt are as we previously defined them
• N(d1) is the probability that a standardized, normally distributed
random variable (i.e., “z” variable) is less than or equal to d1, and
N(d2) is the probability of a value less than or equal to d2
• Suppose we are given the following information and are asked to
find the value of the call option, C:
• S = $100
• E = $90
• R = 4% per year, continuously compounded
• d1 = .60
• d2 = .30
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• t = 9 months
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 THE BLACK-SCHOLES OPTION PRICING
MODEL (CONTINUED)
• Value of the call option is:
C = S × N (d1) − E × e−Rt × N(d2)
= $100 × .7257 − $90 × e−.04(3/4) × .6179
= $18.61

• Generally, we would not be given the values of d1 and d2, and we

would need to calculate them, where the values are given by:

• σ is the standard deviation of the rate of return on underlying asset

• Ln(S/E) is natural logarithm of current stock price divided by
exercise price
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 THE BLACK-SCHOLES OPTION PRICING
MODEL (CONCLUDED)
• Suppose we have the following:
• S = $70; E = $80; R = 4% per year, continuously compounded; σ =
60% per year; and t = 3 months

• Values of N(d1) and N(d2) are .3974 and .2877, respectively

C = S × N(d1) − E × e−Rt × N(d2)
= $70 × .3974 − $80 × e−.04(1/4) × .2877
= $5.03 25-13
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 CALL OPTION PRICING

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 PUT OPTION VALUATION
• Suppose we have the following:
• S = $40; C = $7.53; E = $40; R = 4% per year, continuously
compounded; σ = 80% per year; and t = 4 months
• What’s the value of a put option on the stock?
• Recall the PCP condition:
S + P = E × e−Rt + C
• This condition can be rearranged to solve for the put price:
P = E × e−Rt + C − S
• Plugging in the relevant numbers, the value of the put option is $7.00:
P = $40 × e−.04(1/3) + $7.53 − $40
= $7.00

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 MORE ABOUT BLACK-SCHOLES
• Table 25.4 summarizes the inputs into the option pricing formula
and their effects (positive or negative) on option values
• In the table, a plus sign means that increasing the input increases
the option’s value and vice versa

• Four of the five effects have common names and are collectively
referred to as the greeks

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 VARYING THE STOCK PRICE
• Increasing stock price increases call values and decreases put
values, but strength of effect varies depending on “moneyness” of
the option (i.e., how far in or out of the money it is)
• For a given set of input values, relationship between call and put
option prices and the underlying stock price is illustrated below
• Stock prices are measured on the horizontal axis and option prices
are measured on the vertical axis

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 VARYING THE STOCK PRICE
(CONTINUED)
• Delta measures the effect on an option’s value of a small change in
the value of the underlying stock

• For European options, deltas can be measured as follows:

Call option delta = N(d1)
Put option delta = N(d1) − 1

• For a small change in the stock price, the change in an option’s

price is approximately equal to its delta multiplied by the change in
the stock price:
Change in option value ≈ Delta × Change in stock value

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 VARYING THE STOCK PRICE
(CONCLUDED)
• Suppose we are given the following:
• S = $120; E = $100; R = 8% per year, continuously compounded; σ =
80% per year; and t = 6 months
• Using the Black-Scholes formula, value of a call option is $37.80
• Delta [N(d1)] is .75, which tells us if the stock price changes by $1,
the option’s value will change in the same direction by $.75
• We can check this directly by changing the stock price to $121 and
recalculating the option value
• New value of the call is $38.55, an increase of $.75; so the
approximation is pretty accurate
• If we price a put option using these same inputs, value is $13.88
• Delta is .75 − 1, or −.25
• If we increase the stock price to $121, new put value is $13.63, a
change of −$.25; so, again, the approximation is fairly accurate as
long as we stick to relatively small changes 25-19
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 DELTA

25-20
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 VARYING THE TIME TO EXPIRATION
• Because American-style option can be exercised anytime,
increasing the option’s time to expiration can’t hurt and might help
• For both puts and calls, increasing the time to expiration has a
positive effect
• For European-style call option, increasing time to expiration also
never hurts because the option is always worth more alive than
dead, and any extra time to expiration only adds to its “alive” value
• With a European-style put, increasing the time to expiration may or
may not increase the value of the option
• If a put is out of the money, then increasing the time to expiration
will probably increase its value
• Sensitivity of option’s value to passage of time is called its theta
• Very important to realize that option values are sensitive to the
passage of time (especially call option values)
Option value = Intrinsic value + Time premium 25-21
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 OPTION PRICES AND TIME TO EXPIRATION

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 TIME PREMIUMS

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 VARYING THE STANDARD DEVIATION
• Figure 25.3 illustrates impact on option values of varying standard
deviation of the return on underlying asset
• Effect is positive and pronounced for both puts and calls
• Sensitivity of option’s value to volatility of underlying asset is vega
• Option values are very sensitive to standard deviations
• Changes in volatility of underlying asset’s return can have strong impact
on option values

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 VARYING THE RISK-FREE RATE
• Effect of changing the risk-free rate on option values is shown below
• Increasing the risk-free rate has a positive impact on call values and
a negative impact on put values
• Option values are not as sensitive to changes in interest rates as they
are to, say, changes in volatilities
• Option’s sensitivity to interest rate changes is called its rho

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 IMPLIED STANDARD DEVIATIONS
• In determining an option’s value, the only factor that is not directly
observed (and must be estimated) is standard deviation
• Standard deviation used in the OPM is a prediction of what the
standard deviation of the underlying asset’s return is going to be
over the life of the option

• When the value of an option is known (because its price is

observed in the financial markets), the value of the option can be
used, along with the four observable inputs, to find the standard
deviation
• Implied standard deviation (ISD) is an estimate of the future
standard deviation of the return on an asset obtained from the
Black-Scholes OPM

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 ISD

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 VALUING THE EQUITY IN A LEVERAGED
FIRM
• Consider a firm that has a single zero coupon bond issue
outstanding with a face value of $10 million. It matures in six years.
The firm’s assets have a current market value of $12 million. The
volatility (standard deviation) of the return on the firm’s assets is
40% per year. The continuously compounded risk-free rate is 6%.
• What is the current market value of the firm’s equity?
• Value equity of the firm by plugging numbers into the Black-
Scholes OPM with S = $12 million and E = $10 million, resulting in
$6.554 million as the value of the equity with a delta of .852
• What is the current market value of the firm’s debt?
• Firm’s assets are worth $12 million and the equity is worth $6.554
million, so the debt is worth $12 − 6.554 = $5.446 million
• What is its continuously compounded cost of debt?

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 EQUITY AS A CALL OPTION

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 OPTIONS AND THE VALUATION OF RISKY
BONDS
• Let’s continue with firm that has $12 million in assets and a six-
year, zero coupon bond with a face value of $10 million. Previously,
we showed that the bonds were worth $5.446 million. Suppose
that the holders of these bonds wish to eliminate the risk of
default. How can they do this?
• Bondholders can do a protective put by purchasing a put option
with a six-year life and a $10 million face value
• Risk-free bond is the same thing as a combination of a risky bond
and a put option on the assets of the firm with a matching
maturity and a strike price equal to the face value of the bond:
Value of risky bond + Put option = Value of risk-free bond
• Rearranging, we have:
Value of risky bond = Value of risk-free bond − Put option
= E × e−Rt − P 25-30
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 OPTIONS AND THE VALUATION OF RISKY
BONDS (CONTINUED)
• Value of the bonds if they were risk-free would be:
Value of risk-free bonds = $10 million × e−.06(6)
= $6.977 million
• If we compare this to the value of the risky bonds, $5.446 million,
we see that the put option is worth the following:
$6.977 − 5.446 = $1.531 million
• Using the PCP condition, we can write:
S = C + E × e−Rt − P
• If we are thinking of the stock in a firm as being a call option on the
assets of the firm, and E, the strike price, is the face value of the
firm’s debt, we would interpret this as follows:
Value of assets (S) = Value of stock (C) + (E × e−Rt − P)
• This expression is really the balance sheet identity:
Value of assets (S) = Value of stock (C) + Value of bonds (E × e−Rt − P)
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 MERGERS AND DIVERSIFICATION
• Consider two companies, Sunshine Swimwear (SS) and Polar
Winterwear (PW). For obvious reasons, both companies have
seasonal cash flows; in their respective off-seasons, both
companies worry about cash flow. If the two were to merge, the
combined company would have a much more stable cash flow.
• The operations of the two firms are very different, so the proposed
merger is a purely “financial” merger (i.e., there are no “synergies”
or other value-creating possibilities except possible gains from risk
reduction). Here is some premerger information:

• Risk-free rate, continuously compounded, is 5%

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 MERGERS AND DIVERSIFICATION
(CONTINUED)
• After the merger, combined firm’s assets will be sum of premerger
values, $30 + 10 = $40, because no value was created or destroyed
• Total face value of the debt is now $16 million
• Assume that the combined firm’s asset return standard deviation is
40%, lower than for either of the two individual firms because of
the diversification effect
• What is the impact of this merger?

• Once again, equity and debt values may be calculated as follows:

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 MERGERS AND DIVERSIFICATION
(CONCLUDED)
• This merger is a terrible idea, at least for the stockholders
• Merger neither created nor destroyed value, but it shifted it from
the stockholders to the bondholders
• Before the merger, the stock in the two separate firms was worth a
total of $20.424 + 7.001 = $27.425 million, compared to only
$26.646 million postmerger, so the merger vaporized $27.425 −
26.646 = $.779 million, or almost $1 million, in equity
• Nearly $1 million in equity went to the bondholders
• Bonds were worth $9.576 + 2.999 = $12.575 million before the
merger and $13.354 million after, a gain of exactly $.779 million
• Diversification works in the sense that it reduces the volatility of
the firm’s return on assets, where risk reduction benefits the
bondholders by making default less likely
• Sometimes called the coinsurance effect
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 OPTIONS AND CAPITAL BUDGETING
• For a leveraged firm, the shareholders might prefer a lower NPV
project to a higher one
• When the equity has a delta significantly smaller than 1.0, any
value created will go partially to bondholders
• Stockholders will have a strong preference for variance-increasing
projects as opposed to variance-decreasing ones, even if that
means a lower NPV

• For a leveraged firm, the shareholders might even prefer a

negative NPV project to a positive NPV project
• Stockholders have a strong incentive to increase volatility,
particularly when the option is far out of the money

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 EXAMPLE
• Sunburn Sunscreen has a zero coupon bond issue
outstanding with a $20,000 face value that matures in one
year. The current market value of the firm’s assets is $22,300.
The standard deviation of the return on the firm’s assets is 34
percent per year, and the annual risk-free rate is 4 percent
per year, compounded continuously. The firm is considering
two mutually exclusive investments. Project A has an NPV of
$2,700, and Project B has an NPV of $3,600. As the result of
taking Project A, the standard deviation of the return on the
firm’s assets will increase to 39 percent per year. If Project B
is taken, the standard deviation will fall to 22 percent per
year.
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 • What is the value of the firm’s equity and debt if Project A is
undertaken?
• What is the value of the firm’s equity and debt if Project B is
undertaken?
• Which project would the stockholders prefer?
• Suppose the stockholders and bondholders are in fact the
same group of investors. Would this affect your answer to
(b)?

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 SELECTED CONCEPT QUESTIONS

• What is a protective put strategy?

• Which is worth more, an American-style put or a European-
style put? Why?
• What are an option’s delta, rho, theta, and vega?
• What is the connection between the standard balance sheet
identity and the put-call parity (PCP) condition?
• What is a pure financial merger?

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 END OF CHAPTER
CHAPTER 25

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